Is It Smart to Do an Interest-Only Mortgage?

An interest-only mortage will have lower payments, but greater future risk.

An interest-only mortgage will result in a lower monthly payment for a home buyer. Buyers are attracted to interest-only mortgages so that they can get a larger loan and buy a more expensive home with the same monthly payment when compared to an amortizing mortgage. The problem is that an interest-only mortgage does not stay interest-only forever.

Function

The typical mortgage has a monthly payment that includes interest on the loan and a portion that pays down the principal balance. An interest-only mortgage does not include the principal repayment part. Each monthly payment is entirely interest due on the loan; the mortgage balance does not get paid down. The result is a lower monthly payment for an interest-only loan as compared to a repayment mortgage.

Effects

The monthly payment on a $400,000 loan at 6 percent would be $2,398 for a traditional mortgage. With an interest-only loan, a monthly payment of $2,400 would qualify the borrower for a $480,000 loan. The standard mortgage would initially have about $400 per month going to pay down the loan balance; the interest-only loan's principal would stay at $480,000.

Time Frame

An interest-only loan has the interest-only feature for a set period, usually three, five or 10 years. After the interest-only period expires, the mortgage payment will change to pay off the loan in the remaining term. For example, if a $480,000 interest-only loan starts paying off after a five-year interest-only period, the monthly payments will go up to $3,092 in the sixth year and stay at that amount until the loan is paid off.

Considerations

An interest-only loan makes sense in a few circumstances. The homeowner may have a job with a large annual bonus. The interest-only loan will keep the monthly payment low, and the homeowner can send a large check to pay down the principal once a year. If the principal is paid down, the new interest-only payment will be lower. Sometimes a homeowner may be able to afford a larger amortizing payment, but would rather have the low, interest-only payment so that he can invest the difference elsewhere. As a financial planning technique, the homeowner may want to keep the tax-deductible home-loan interest payments high and use the extra money for investments that provide a better return.

Significance

If the homeowner cannot afford the payments when the interest-only period ends, this type of mortgage is probably not a smart option. If the value of the house increases, the homeowner may try to sell it before the higher mortgage payments start--but that is a gamble. An interest-only mortgage can be used as a financial planning tool if the home buyer understands the consequences and can afford payments 25 to 30 percent higher when the interest-only period ends.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.